(Editor's note: This post forms part of the month-long HBR Debate, "Finance: The Way Forward." It is the third post on this week's topic: "Do we really need banks — and what might take their place?")
If there is one strong message to come out of the banking crisis, it is that we need banks but not banks like the ones we have got. Banking keeps the modern economy ticking and without banking, it dies. We know that because there was a worked example in 2007-8 when major banks got into difficulty. Governments looked at the option of letting them fail, tried it in one case, Lehman, and rapidly concluded that there was no alternative but to put aside their dislike of back-door socialism and bail the others out.
Bank bashing is a popular sport right now but it is really extraordinary that things have got so bad for them because it is hard to think of many businesses that play a more important role in a capitalist economy. Banks take surplus cash from people, businesses and sovereign states and lend it to counterparties that need money. This sets in motion vital social and economic actions including loans for home ownership, capital for business development and funds for infrastructure investment.
If banks did not provide this intermediation service, money would stick with those that already had it and the existing distribution of wealth would be entrenched and magnified. Home ownership could only be achieved through inheritance, it would be hard to start new businesses and progress in the developing world would be slower. Banks, then, are the agents of the economic mobility that underpins a fair and fluid society.
Unfortunately other missions have crowded out this core function over the past quarter century. Banks' shareholders pressed them to grow profits at an ever-faster pace and banking executives, aided by technology and deregulation and incentivised by generous compensation arrangements, got to work. Financial innovation morphed from a tool to facilitate capital flows into a moneymaking technique for the bankers and their shareholders. Profit, both personal and corporate, became a primary objective rather than the just reward for good customer service and responsible growth. Banks became unrecognizable conglomerates doing a myriad of things that added little value to and often detracted from the socially useful activity that was at their core.
The way out of this is not to ban banks or to replace them with a different type of financial institution but to refocus them on their basic purpose. Society needs banks to bring together savers and borrowers, spread risk and operate the payments system. It needs them to do this in a secure, transparent way and for bankers and shareholders to be appropriately rewarded for so doing. Multimillion-dollar guaranteed bonuses and returns on equity in the high teens are not likely to feature in these rewards.
The other things that today's banks do involving excessive leverage and frenetic trading as a means of making money for themselves and their clients have no place in the core banking system. The institutions that carry out such activities need to be regulated in order to ensure that they do not become system threatening or too closely connected to the core banking structure. This implies a rearrangement of the global financial architecture — and I do not underestimate the difficulty of achieving the global coalition that this would require. But I am convinced that unless we give basic banking room to breathe, social and economic progress will be regularly interrupted by massive setbacks of the kind we are presently going through.